Whistleblower Tip From High Frequency Trader Leads To Record SEC Fine of $14 Million for Stock Exchange Operator


As we approach the five year anniversary of Dodd-Frank this year, it could be a banner year for the announcements of awards as investigations resulting from early whistleblower tips mature.  We got our first example this week.  On Monday, the number two U.S. stock market operator, BATS Global Market, agreed to pay a record $14 million to settle SEC allegations resulting from a whistleblower tip in 2011.

The allegations concerned the selective disclosure of the operation of certain order types to high-frequency trading firms (HFT) by two exchanges formerly owned by Direct Edge Holdings and acquired by BATS.

The Hide Not Slide (HNS) order type was developed at the request of a significant HFT. It changed the rules for price sliding and time stamping that could be expected from ordinary limit orders.

Direct Edge, as part of its development of a new technology platform and upgrade to national securities exchanges, then solicited additional feedback about HNS from two HFTs. It made additional modifications to the order type as a result of these discussions.  Direct Edge did not not announce these changes, did not update its exchange application with the SEC and did not seek approval for changes to rules related to its order types.

Complete and accurate information about the operation of the HNS order type was provided only to the two HFTs. Subsequently, Direct Edge provided information to another HFT and other market participants about NHS.

Hide Not Slide was created to attract high-frequency trading firms to the Direct Edge exchange. HNS orders were not displayed to the rest of the market and in some cases traded ahead of one-day limit orders.

The whistleblower, an experienced trader on Wall Street, ran a high-speed trading firm in 2009 when his stock trades started losing money. Traders at other institutions had switched to HNS. His continued use of plain vanilla limit orders was costing him money as other traders had an advantage. He did not understand what happened until an employee of Direct Edge suggested that he should make the switch to Hide Not Slide. In 2011, he tipped off the SEC to the advantage given to some high-frequency traders by this order type.

The SEC investigation resulted in fines related to the disclosure of the rules only to select market participants. The fines also resulted from the the modification of exchange rules without seeking the approval of the SEC and the failure to provide the SEC accurate information about the operation of the order type.

The SEC order did not take issue with the more controversial aspect of the order type – its ability to allow certain sophisticated traders to get an advantage over other investors using limit orders.  High-frequency trading continues to be an area of investigation but there have been few prosecutions.

The SEC announced its first prosecution of high frequency trading manipulation in October when a trading firm agreed to pay $1 million to resolve the investigation into its rapid-fire orders in thousands of NASDAQ stocks placed in the last two seconds of trading every day for six months.  Back in 2012, the SEC also fined NYSE Euronext for providing information to certain traders faster than it did a public database.

No award has been issued to the individual who provided the tip to the SEC yet. The SEC will post a notice of covered action to its website and the whistleblower will need to submit a claim for award. If the SEC determines the whistleblower eligible, it will. It will take several months for this process to be completed and an award or denial ruling.

An award in this case would be further confirmation of the important role that customers and competitors can play to police the markets through the SEC whistleblower program. The individual was a competitor of the high frequency trading and a customer of the stock exchange fined. He was not an insider or employee of either company. In fact, employees of self-regulatory organizations such as BATS are specifically prohibited from receiving an award under the rules of the SEC program.

The $14 million penalty topped the previous record by $4 million. Nasdaq paid $10 million to the SEC in May 2013 over its handling of the Facebook IPO.